67 Trillion Reasons to be Cheerful, the Shadow Banking System

David Rose writes: The much-maligned ‘shadow banking’ sector has so far been accused of causing the global financial crisis, restricting access to capital and, probably, global warming too. But maybe the time has come to bring ‘shadow banking’ out of the shadows and into the light, so that the discussion can become a little more constructive.

The Financial Stability Board’s (FSB) Global shadow Banking Monitoring Report 2012 shows that ‘shadow banking’ “…grew rapidly before the crisis, rising from $26 trillion in 2002 to $62 trillion in 2007”. The 2011 count was $67 trillion. That’s $67 trillion free of banks who cannot lend because they are trying to rebuild their capital bases, and $67 trillion free to invest in worthwhile projects by those who actually own the money. Indeed, 67 trillion reasons to be cheerful and positive about ‘shadow banking’ or, to use the name given to it by those of us active in the market, ‘alternative capital’.

The reality behind this growth of the alternative capital 2002 and 2007 is not some kind of conspiracy, which appears to be implied in the FSB report, but the flight of capital from mainstream banks into hedge funds, asset managers and others which comprise the alternative capital sector. This migration of capital took place over the decade before the crisis manifested itself in 2008.

The people who own this money, wealthy individuals comprised mostly of successful entrepreneurs, could see what was coming long before the collapse of 2008, and began moving it out of the mainstream banking network in order to separate it from the carnage they so accurately anticipated. A useful analogy would be the flight of wildlife as it heads for the hills before a tsunami arrives. The wealthy share similar instincts, and responded accordingly.

In short, these unprecedented global capital flows resulted in a net reduction of balances for the established banking network as it took refuge in hedge funds, family offices, asset managers, investment consortia, syndicates and a host of other vehicles. It is this private money that underpins the rapidly emerging alternative capital market.

The reality is that the banking crisis was brought about by the banks’ own hubris – with some notable exceptions. Many of us saw it coming a decade before it actually happened, with the catalyst being the creation of mountainous debt among those who stood no chance of repaying it. A child could have seen that it was unsustainable. How strange (and sad) that the participating banks themselves, media commentators, battalions of highly paid economists and the credit rating agencies didn’t see it coming as well. The OECD mentioned the ‘global financial crisis’ in research produced for their 2006 Pensions Report, which means that it was already by then an established part of their thinking.

Alternative capital is now a force to be reckoned with and, in its own anarchic way, starting to show some signs of structure, to a point where it could actually become a tangible and credible permanent alternative to established banking and financing channels. Alternative capital being fed into the markets through these much maligned ‘shadow banking’ channels is picking up where traditional mainstream banks have failed. Perhaps it is time to start regarding this sector as part of the solution, as opposed to part of the problem.

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